Wednesday, March 23, 2011

Predicting China's inevitable slowdown

"If something cannot go on forever, it will stop."

- Herbert Stein

China's rapid growth has been going on for 30 years, but it can't go on forever. This is one of the most basic facts in macroeconomics, confirmed by every single observation and supported by every single theory at our command. When a developing country's per-capita income approaches that of the richest countries, it cannot grow much faster than the richest countries.

The question is, when? How rich will China get before it stops posting blistering growth rates? Answers vary widely.

In recent work, Kwanho Shin of Korea University and I studied 39 episodes in which fast-growing economies with per capita incomes of at least $10,000 experienced sharp and persistent economic slowdowns. We found that fast-growing economies slow when their per capita incomes reach $16,500, measured in 2005 US prices. Were China to continue growing by 10% per year, it would breach this threshold just three years from now, in 2014.

There is no iron law of slowdowns, of course...slowdowns come sooner in countries with a high ratio of elderly people to active labor-force participants, which is increasingly the case in China, owing to increased life expectancy and the one-child policy implemented in the 1970’s.

Slowdowns are also more likely in countries where the manufacturing sector’s share of employment exceeds 20%, since it then becomes necessary to shift workers into services, where productivity growth is slower. This, too, is now China’s situation, reflecting past success in expanding its manufacturing base.

Most strikingly, slowdowns come earlier in economies with undervalued currencies. One reason is that countries relying on undervalued exchange rates are more vulnerable to external shocks. Moreover, while currency undervaluation may work well as a mechanism for boosting growth in the early stages of development, when a country relies on shifting its labor force from agriculture to assembly-based manufacturing, it may work less well later, when growth becomes more innovation-intensive.

Finally, maintenance of an undervalued currency may cause imbalances and excesses in export-oriented manufacturing to build up, as happened in Korea in the 1990’s, and through that channel make a growth deceleration more likely.

For all these reasons, a significant slowdown in Chinese growth is imminent.

I have a slight problem with Eichengreen's math here. He claims that slowdowns happen around a per capita GDP of $16,500 in 2005 dollars. China's per capita GDP in 2010 was about $7,500 in purchasing power parity terms (at market exchange rates, it was less than 2/3 of that). In 2005 dollars, it was about $6,500 (subtract 14% for inflation). Assuming a continued 10% rate of growth, as Eichengreen does, I calculate that China will pass the $16,500 mark in 2020, not 2014 as Eichengreen states.

So it seems that Eichengreen was either using some very different numbers, or made a math error. Assuming that the other factors he cites knock another 3 years off the time until the slowdown, we get 2017.

The World Bank today said China has the potential to achieve an annual growth rate of 8 per cent for another 20 years, with latent possibility to outgrow the US economy.
Estimates showed that China's current relative status to the US was similar to Japan's in 1951, and South Korea's in 1977, who were in their high-speed development period, World Bank Chief Economist and Senior VP Justin Yifu Lin said.

Wow, that's 16 years later than Eichengreen's prediction - which, at high growth rates, is a factor of 4 difference in total GDP! Even if Eichengreen got his numbers wrong and his model predicts a slowdown in 2020, that's a 10-year difference, or a factor of 2.5. Why the big discrepancy?

Well, three reasons:

1. The World Bank assumes that some of China's slowdown will come immediately. They predict 8% growth rather than 10% (and keep in mind, Eichengreen's predicted slowdown was a drop to 7%). Mildly slower growth will delay the day of much slower growth.

2. The World Bank assumes that China's growth will fall when it reaches half of U.S. GDP; for Eichengreen's model, the cutoff is 41%.

3. The World Bank assumes that the trigger for slower growth happens at a percent of future U.S. GDP, while Eichengreen assumes that it happens at a percent of 2005 U.S. GDP. Since the U.S. is still growing, this subtracts from the effective growth rate that the World Bank is using for its calculations. With a very optimistic assumption of 3% U.S. growth, that means that a China growing at the World Bank's 8% figure would only be approaching the World Bank's slowdown cutoff at a rate of about 5%.

So who's right? It depends on two things: A) China's growth rate in the near future, and B) the location of the mysterious "slowdown cutoff" at which rapid catch-up growth hits diminishing returns.

On the former issue, I tend to agree with Eichengreen. China's leaders regularly declare their intent to lower growth to a slower, more sustainable level, but so far it has never happened. Not only do local leaders often ignore the central government's diktats, but the central government itself seems unwilling to appreciate its exchange rate or to halt the flood of cheap capital that it forces its banks to provide. The government is too afraid of a sharp slowdown to allow a gentle one. So I also predict that 10% growth will continue to be the norm for this decade.

Making that modification, the World Bank's prediction drops to 2023. The remaining 3-year discrepancy between the (math-corrected) Eichengreen base case and the World Bank's prediction is down to the different assumption about the cutoff. If you believe Eichengreen's list of exacerbating factors, the discrepancy is 6 years (2017 vs. 2023), or still nearly a factor of 2 for the Chinese economy.

So, basically, expect China to slow sometime late this decade or early the next decade. For my own on-the-record prediction, I'll go with an average of the professionals, and make it 2020. At that point, China's total GDP (PPP) will be about $25 trillion, or about 1.5 times the size of the U.S. economy.

1 comment:

Presumably the secular trend involves a relatively slow diminishment of growth rates over time. The reality is unlikely to be so slow: most rapidly growing economies, like China, have experienced sharp, sometimes severe, recessions along the path to a slower pace of growth. They recover, of course, and growth continues at a rapid, but more mild pace than before.

But, in the moment, the severity of recession can cause great distress and motivate political reform or upheaval.

The many reports of dislocation in the Chinese economy and lagging institutional development suggest to my mind that China may be in for a particularly severe growth-recession.

Perhaps, Eichengreen, as a student of the Great Depression, was reaching for the timing of such a downshift recession? While the World Bank was casting the runes on the secular trend without considering the downshift-recession at all?